Economist, Telegraph Columnist, Broadcaster

Will Cyprus be the pin to burst the euro balloon?

It’s tempting to dismiss events in Cyprus as insignificant. Mainstream politicians and investors, desperate to keep the flame of Western recovery flickering and the asset price rally on track, insist that the country is “a special case”. After all, they say, this tiny Mediterranean nation accounts for less than one third of one percent of the Eurozone economy.

The hole caused by a pin, though, is an even smaller percentage of the surface area of an inflated balloon. It still causes a pretty big bang. The hard, sharp realities of the single currency’s internal contradictions, similarly, now loom over all member states and, in fact, the entire world economy.

The Eurozone, taken together, is the second-largest economy on earth and, surely, the region most likely to spark a systemic lurch on global markets, yanking us back to the bad old days of “risk-off”. Cyprus could be the pinprick that bursts the eurozone’s balloon. The political and financial edifice that is monetary union looks more susceptible than ever to an explosive and damaging outcome.

The European Central Bank has given Nicosia until Monday to present a credible method of bridging its €6bn funding gap, or face the immediate withdrawal of cash lines to Cypriot banks. Laiki Bank and probably Bank of Cyprus too, the biggest banks on the island, would probably be rendered insolvent. Under the latest plans, which seem to be change hourly, deposits below €100,000 would be protected, with bigger balances transferred to a “bad bank” along with non-performing loans. That could easily see large depositors, many from overseas, suffering losses way beyond the 9.9pc tax that was previously proposed but now seems off the table.

Pulling the plug is almost certain to spark an extremely chaotic outcome. That’s why the ECB – that is Germany – is highly unlikely to do it in my view. A Cyprus bank run could easily spark copycat outcomes in other highly-indebted Eurozone countries with weak banks, not least Italy and Spain – economies which are, respectively, 60 times and 90 times bigger than Cyprus.

The disorder and resentment caused by a bank run “imposed by Europe” would almost certainly result in serious civil unrest in Cyprus, with the country possibly crashing out of the euro on a wave of public disgust. Once that line had been crossed, the myth of membership “irreversibility” exposed, there would be talk of other weak but much larger nations quitting the Eurozone – and even some stronger countries too. Market speculation could then make such an outcome unstoppable.

Such a scenario, which some of us have warned about for years, can no longer be seen as hyperbole. That’s why, for now at least, the most likely outcome is that Berlin will blink and we end up with more “muddle through”. Demanding that Cyprus raise €6bn – almost a quarter of it annual GDP – over a weekend is “a big ask”. Having said that, I think the “Solidarity Fund” approved by the Cypriot Parliament will form the basis of some kind of temporary solution, issuing collateralized debts backed by a pool of state assets (possible linked to natural gas reserves) and maybe even church property too.

While Finance Minister Michael Sarris returned from Moscow seemingly empty-handed, don’t write-off the idea of Russian support also materializing. With Cyprus located at the fringes of Europe, on the fault-line of West European, Slavic and Arab spheres of influence, there’s a lot more at stake, of course, than the estimated €20bn of Russian deposits stuffed in Cypriot banks.

For all the huffing and puffing by Western “Cold War Warriors” in recent days, Russia already loaned Cyprus €2.5bn back in 2011, during the last big Eurozone flare-up. At that time, International Monetary Fund supremo Christine Lagarde even visited Russia herself, inviting the Kremlin to contribute to the European Financial Stability Mechanism – a special purpose vehicle that’s under-pinning the bond-markets of some core Eurozone members. So, if it comes to it, Western Europe won’t stop the Cypriots taking more Russian money.

While it’s good that the crass stupidity of confiscating small savers bank deposits now looks unlikely, I cannot believe such an idea was ever proposed. To have taken this draconian step would not only have breached a Eurozone guarantee extended just a few years ago, when this ghastly crisis began. It would also have been the most efficient way imaginable to spread conflict and political extremism across Europe, while undermining the financial and legal fabric of capitalism itself.

The widening of bank and sovereign spreads that would have resulted from breaching the guarantee on small deposits would anyway have cost Eurozone governments many, many times more than they would have “saved” by refusing funds to Cyprus. The idea was utter lunacy and yet it was put forward, in all seriousness, by politicians and officials from both Berlin and Brussels. One wonders if these people have any grasp of basic economics.

If we do get more “muddle through”, market calm will only be restored due to the programme unveiled by ECB boss Mario Draghi last summer, under which the central bank buys the sovereign bonds of otherwise bankrupt Eurozone members. Keep in mind, though, that this facility hasn’t yet been used, not least as the conditions Germany has attached are so harsh that no democratically-elected government has wanted to accept them.

The real deadline for the Cypriot government is 3rd June, when a $1.2bn international loan comes due. But even if Cyprus is “resolved” before then, this squabble has done serious political damage. The 36-0 rejection of Germany’s “savings tax” proposal by the Cypriot Parliament amounted to a two-word message, the second of which was “off”. Not only in Cyprus, but in Italy and Spain too, even in Germany itself, populist politicians are promoting “anti-euro” messages with growing confidence as patience with the “European project” wears thin. So it will become even more difficult over the coming months for an insolvent Eurozone nation to accept ultra-tough bond-buying requirements, or for Berlin to ease those conditions. If investors perceive the divide as too wide, and judge the activation of Draghi’s bond-buying as politically impossible, then all bets are off.

While I’ll return to UK fiscal policy in future columns, the main point I want to make about last’s week budget statement, in the space I have left, is that it always makes sense to treat what is actually said with skepticism and focus instead on the fine print.

“We’ve taken the tough decisions to bring the deficit down,” said George Osborne, to the House of Commons and the country. The UK is set to register a 2012/13 fiscal shortfall of 7.4pc of GDP. This is lower than 11.2pc in 2009/10 but still bigger than when we went “cap in hand” to the IMF in 1976.

The budget documents show that, even if growth recovers, the UK will borrow a total of £512bn between 2012/13 and 2016/17. That’s up from a borrowing estimate in the 2012 budget documents of £338bn over the same five-year period. So there was a staggering £174bn increase in our national debt buried in the budget fine print. And for all the talk of “austerity”, that debt – which we must service, of course, before eventually paying-back – will rise by 40pc over the next five years. Rather than trying to disguise such horrific realities, the Tories should be shouting them from the rooftops. Only then would voters grasp the enormous scale of the fiscal challenge we face.